1. Derivatives and Shareholder Value: A Comprehensive Guide for Corporate Users of Derivatives David C. Shimko Senior Lecturer, Harvard Business School Managing Partner, Risk Capital Management Partners, LLC david.shimko@e-rcm.com 27 August 2003 Seoul, South Korea First Seoul International Derivatives Securities Conference

2. 1 Outline of this talk: Top questions What is a corporation’s risk profile, and why is it important? If derivatives represent pure risk transfer, then how do derivatives add to corporate shareholder value? When do corporations mis-use derivatives? What do companies need to do before trading derivatives? Can we learn from derivatives disasters outside of Korea? Begin with a case study: International airline company

3. 2 Begin with the usual financial statement forecasts Revenues and most costs are divided by region Corporate costs include overhead and executive salaries Interest costs are forecasted from all sources, fixed & floating, all currencies Jet fuel costs are segregated for further analysis DivisionExp Cash Flow in 2004 ($MM) Europe $400 Americas 500 Australasia 300 Africa/Mideast 200 Corporate (200) Interest (150) Jet fuel (300) Sum $750 Europe Americas Australasia Africa/Mideast Corporate Interest Jet fuel Sum Cash flow by division

4. 3 Are the forecasts sufficient? Expected cash flow is $750MM How much cash is “at risk” to earn $750 MM? –$50 MM at risk  High quality cash flows, better investment –$900 MM at risk  Low quality cash flows, weaker investment

5. 4 Rethinking ROI We usually measure return on investment “Return on risk” is a better measure Example: –New airline route development costs $200 MM Route AECF = $49 MMCFAR = $4 MM Route BECF = $50 MMCFAR = $35 MM –Route B has a higher ROI –Which investment would you take? –How did we make these decisions without risk analysis in the past?

6. 5 RISK: The second dimension ExpectedAt Risk Europe 400 200 Americas 500 350 Australasia 300 100 Africa/Mideast 200 250 Corporate (200) 75 Interest (150) 45 Jet fuel (300) 120 Sum 750 1,140 Diversified 750 560 Risk of the “portfolio” is much less on a diversified basis Need to understand risk of each unit on a standalone basis

7. 6 Risk Map of the Airline Business International Airlines CFAR Analysis Diversified Sum Europe Americas Australasia Africa/Mideast Corporate Interest Jet fuel (400) (200) - 200 400 600 800 1,000 -4006008001,000 Cash Flow at Risk Expected Cash Flow

8. 7 What does the graph tell us? The airline reduces 50% of its risk through diversification of international operations The airline has less than a 5% chance of negative cash flow Australasia is –Less profitable than the Americas business –But adds cash flow with much less risk –  Higher quality earnings Africa/Mideast is –A weaker contributor to cash flows –And high risks may or may not help diversify portfolio

9. 8 Analyzing a jet fuel derivative: Buy fuel forward? 1: Jet fuel hedging –Note that rising jet fuel costs reduce travel revenues –But may reduce fuel consumption due to weight variations –Determine the correct hedge ratio considering all risks Consider diversification benefits existing in the business Take advantage of natural offsets Goals of hedging –Reduce jet fuel risk? Not necessarily –Reduce corporate risk? Not necessarily –Improve the level and quality of corporate cash flows? YES!!!

10. 9 Analysis of a jet fuel derivative hedge International Airlines CFAR Analysis DiversifiedSum Europe Americas Australasia Africa/Mideast Corporate Interest Jet fuel (400) (200) - 200 400 600 800 1,000 -2004006008001,0001,200 Cash Flow at Risk Expected Cash Flow Slightly lower cash flow due to illiquidity and contango Market view or backwardation may imply a gain Significant reduction in risk (at correct hedge ratio) Overall increase in earnings quality

11. 10 Analyzing a fixed/floating interest rate swap Interest rate swap –How does an airline decide between fixed and floating rate debt? Cost of floating tends to be lower than fixed Floating has higher risk for corporations FX denominated debt may hedge some airline revenues in the same currency Borrowing in some currencies tends to be more expensive than others POSSIBLE ANSWERS –A. Depends on the interest rate and FX view: Go with the strategy that is expected to be cheapest –B. If this is not your core competency, rely on the investment banker recommendation –C. Minimize interest rate risk –D. Minimize FX exposure –E. Increase overall quality of cash flows by balancing reduced costs with increased risks

12. 11 How should a company manage its derivatives? Firms need to understand their exposures –Measure known exposures –Find hidden exposures –Understand offsets, concentrations and diversifications –Protect against disruptions to the capital plan –Understand shareholder goals Strategies must be designed and tested to ensure they actually reduce risk Firms need to manage “earnings quality” –Analysts value quality earnings –Firms with higher quality earnings have higher P/E multiples CFAR leverages the contribution and value of the financial organization in the firm overall A common language and culture of risk ensures consistent decision-making across very different divisions

13. 12 Learning from derivatives disasters Metallgesellschaft AG –Hedged long-dated fuel exposures with short term oil futures –Overhedged by 100% –Underestimated margin requirements Barings –Leeson manipulated operational controls to establish fraudulent accounts Sumitomo –Hamanaka sells in-the-money call options on copper –Raised money to support a failing trading operation

14. 13 More disasters Enron –Corporate failure was a case of fraud not derivatives abuse –However, Enron sold protection against Enron’s own default (credit derivative swaps) Williams, Aquila, Mirant –Energy liquidity crisis brought trading to a halt –Companies did not adequately measure cash margin needs Proctor & Gamble –Treasurer reduced current debt cost while increasing exposure to future interest rate changes –Accepted advice of conflicted investment bankers –Bankers made millions from this advice

15. 14 Conclusions Corporations can add a great deal of value to shareholders by managing risks properly Steps to successful risk management –1. Understand your natural portfolio and risks –2. Do not use derivatives to target a particular risk –3. Remember that the use of derivatives brings counterparty performance risk, cash margining risk, and operational risk –4. Know the difference between hedging and speculation; speculation is OK with the right performance measurement. –5. Good operational policies and controls can minimize these incidental risks. –6. There are strong benefits to making the entire organization aware of the risks they take. –7. Consider hiring a risk management advisor for large trading and hedging decisions.